Will FDIC Junk Bank of America, Citigroup? Street Whispers

In June, investors braced for the prospect that rating agency Moody's would cut some of America's largest banks like Morgan Stanley(MS), Bank of America (BAC), and Citigroup (C) to levels barely above junk.

The downgrades came out less harsh than expected as Moody's painted an optimistic picture on the capitalization and balance sheets of US lenders, in spite of earnings and macroeconomic headwinds.

Now Uncle Sam is poised to change the rating agency's mind, raising the prospect that struggling lenders like Bank of America, Citigroup, and Morgan Stanley continue a slide toward junk.

In a September 4 note, Moody's indicated that as the Federal Deposit Insurance Corporation works to end "Too Big to Fail," a ratings subsidy that supports the the largest US banks, the investible rating for JPMorgan(JPM), Bank of America, Citigroup, Wells Fargo(WFC), Goldman Sachs(GS) and Morgan Stanley, may be sent downward.

A prospective full withdrawal of a Moody's ratings subsidy on some "too big to fail" bank debt may push industry laggards like Bank of America and Citigroup into junk territory -- a rating that would likely raise borrowing costs and cut at profitability and liquidity.

The end of the subsidy, Moody's indicates, hinges on whether the FDIC can use new Orderly Liquidation Authority power granted under the 2010 Dodd Frank Act to actually untangle systemic banks. Signs of success would put two-to-three notch rating subsidies for Bank of America, Citi, and Morgan Stanley at risk, the logic shows, while maintenance of "too big to fail" would keep them intact.

Moody's updated ratings calculus signals that investors playing a rebound in those banks should prepare for an end of "too big to fail," with the prospect that some advantages go away nearly four years after the government embarked on a bailout of America's largest banks.

The key is that as the FDIC defines how it would implement an orderly liquidation of a systemic bank, Moody's expects bank holding company creditors to suffer as regulators focus on keeping a bank's systemically important operating entities running.

Moody's assessment comes after a May presentation from FDIC chairman Martin J. Gruenberg indicated that the agency would put holding company bonds into FDIC receivership, in a move that law firm Morrison Foerster said could wipe out shareholders and convert unsecured junior and senior creditors into equity holders -- or wipe both out.

A plan for orderly liquidation that focuses on maintaining capital at a bank's operating subsidiaries at the expense of holding company creditors "at best will cause the premium on such debt to rise and, at worst, will cause the market for the senior unsecured debt of systemically important institutions to dry up, regardless of the financial strength of particular institutions," wrote the law firm in a May 16 client note.

Moody's ratings outlook divergence between operating and holding company support for systemic banks appears to confirm those thoughts. Currently, the outlook on operating subsidiary support is "stable," while it is "negative" for holding company debt. The key to any ratings downside hinges on whether the FDIC will be expedient in defining its liquidation plans.

By focusing on imposing holding company creditor losses as part of a recapitalization plan and orderly liquidation, "the FDIC has effectively acknowledged that it would be exceedingly difficult to resolve a complex, interconnected firm in its entirety," writes Moody's in its September 4. outlook.

Still, the likelihood is that the FDIC and other regulators are likely to make progress on the end of "too big to fail,' with the prospect that the ratings of Morgan Stanley, Bank of America, and Citigroup are pressured further toward junk levels.

"While hurdles remain, we believe it is reasonable to expect that the FDIC may become more confident over time in its ability to successfully resolve large and complex firms, which could justify a reduction in our support assumptions for large US bank holding companies from their current levels," notes Moody's.

Investors interested in playing the game theory surrounding subsidies may be wise to watch how banks respond.